South Eastern Europe Economic Outlook June 2018

South-Eastern Europe: Economic growth ebbs in the first quarter but stays solid

June 4, 2018

South-Eastern Europe’s (SEE) economy is expected to have grown 4.6% in Q1, according to a more comprehensive estimate. This is below last month’s estimate of a 4.7% expansion, and comes on a significant slowdown in Romania, the region’s second-largest economy in nominal GDP terms. Q1’s growth was also down substantially from Q4’s 5.8%, driven by an expected loss of momentum in regional giant Turkey on slower credit growth and a weaker external sector.

A flash estimate put growth in Romania at 4.0% in Q1, markedly below analysts’ expectations and suggesting the impact of the government’s fiscal stimulus is starting to wane. Although a breakdown by GDP components is not yet available, the sharp slowdown in retail sales growth in the quarter suggests households are feeling the pinch from higher inflation and interest rates, and the rise in social security contributions from 1 January. Also, the trade deficit widened substantially year-on-year, suggesting the external sector subtracted from growth.

In contrast, Serbia enjoyed a stellar Q1, with growth accelerating to a near ten-year high thanks to a surge in fixed investment, which was likely supported by FDI inflows and the Central Bank’s looser stance since the second half of last year. In addition, higher public spending on wages and pensions supported private consumption. However, the external sector subtracted from growth, with import growth outpacing export growth on solid internal demand. Croatia also saw a pick-up in growth on strong private consumption, underpinned by a healthy labor market.

Greece performed better than expected in the first quarter according to data released on 4 June, thanks to a surge in exports. The solid external sector more than offset a fall in fixed investment due to a strong base effect. However, private consumption was sluggish, showing that consumers are still smarting from many years of harsh austerity measures. Meanwhile, a flash estimate for Bulgaria had growth stable from the prior quarter.

So far in the second quarter, economic instability in Turkey has dominated headlines in the run-up to crucial presidential and parliamentary elections on 24 June. On May 23, the lira plunged in value as investors lost confidence in the Central Bank’s willingness to rein in inflation, against a backdrop of rising economic imbalances, a widening current account deficit and ongoing government stimulus measures. Although a semblance of stability has since been restored to the FX market, following Central Bank moves and assurances by top officials, the lira is still among the worst-performing emerging market currencies so far this year. This is raising pressure on Turkish corporations—who hold substantial foreign currency debts—and generating economic uncertainty. Credit rating agency Moody’s put Turkey’s credit rating on review in early June, citing worsening external metrics and a loss of investor confidence in the country.

Financial volatility, high inflation and weak lira are generating uncertainty and appear to be dampening economic momentum. In the first two months of the second quarter, business and consumer sentiment in Turkey soured, while the manufacturing PMI has crashed into negative territory. Indicators for other major players, while limited, also point to easing momentum: At the outset of Q2, industrial production softened in both Croatia and Serbia, while the Greek manufacturing PMI has averaged lower compared to in Q1.

The regional economy is seen expanding a still robust 3.8% this year, down slightly from last month’s 3.9% growth projection and well below the 5.8% expansion recorded in 2017. This is largely because growth in Turkey and Romania is set to slow from unsustainably high levels as the impact of expansionary fiscal policy gradually fades and tighter credit conditions hit private consumption and investment. On the other hand, the Greek economy should continue to gain momentum this year on a solid external sector, although nominal GDP will still be significantly below its pre-crisis level. Elsewhere in the region, stronger absorption of EU funds across the Balkans, resilient external demand and improving tourist arrival numbers should support economic activity. The regional economy is expected to expand 3.4% in 2019.

The downgrade to the regional GDP forecast for 2018 largely reflects slower-than-expected growth in Turkey this year, which was likely driven by recent financial instability forcing the Central Bank to tighten monetary policy significantly. Romania also had its growth forecast downgraded this month following Q1’s weak outturn, as did Bulgaria. In contrast, Bosnia and Serbia saw their forecasts hiked, while the region’s remaining economies saw their projections unchanged.

Despite receiving downgrades this month, the economies of regional heavyweights Romania and Turkey are expected to grow at the fastest rates in the region this year, with expansions of 4.4% and 4.3%, respectively. At the other end of the spectrum, Greece is projected to record the weakest expansion in the region, at 1.9% growth.

TURKEY | Momentum ebbs and financial instability rears its head in the build-up to the June elections

Although GDP figures for Q1 are still outstanding, the latest signs point to ebbing momentum in the run-up to general elections on 24 June. In May, the manufacturing PMI dived further in negative territory on lower output and new orders, while consumer and business confidence declined in the same month. In addition, in March industrial production growth moderated for the third consecutive month, despite remaining robust. On the positive side, the unemployment rate has fallen markedly so far this year in annual terms. There are, however, signs of rising imbalances, with the current account deficit ballooning in the first three months of the year on surging imports; this poses a risk to the economy, given that the deficit is financed in large part by short-term capital flows. The weaker external position has put pressure on the lira, which is down sharply since the start of the year. This is fanning inflation and putting pressure on businesses, many of which hold substantial foreign currency debt.

The economy should lose steam this year after performing above potential in 2017, as credit growth eases amid tighter financial conditions, and fiscal stimulus gradually dims. Exchange rate volatility, geopolitical tensions, a widening current account deficit and elevated inflation pose downside risks. FocusEconomics panelists expect growth of 4.3% this year, which is down 0.1 percentage points from last month’s estimate. They see growth of 3.8% in 2019.

Following buoyant growth in 2017 on the back of surging consumer spending and lax fiscal policies, the economy slowed sharply in the first quarter. While a breakdown has yet to be released, much weaker growth in retail sales in Q1, together with soaring inflation, indicates that a marked weakening in household spending drove the deceleration. Economic overheating leading to growing capacity bottlenecks—as suggested by some weakness in industrial activity—was also likely responsible for the slowdown. Moreover, the government’s spendthrift fiscal stance led to the consolidated budget recording a deficit in the first four months of this year, swinging from a surplus in the same period of 2017. This prompted a severe reprimand of the cabinet by President Iohannis, further complicating already strained relations. The government, however, stated that it will maintain an expansionary fiscal stance until 2020. Compounding political tensions, anti-corruption demonstrators returned to the streets in mid-May to protest the government’s attempted overhaul of the judiciary.

Growth will ease considerably this year but should remain healthy. Although fixed investment is expected to increase faster than last year on rising EU funds, higher inflation and a moderation in wage gains will lead to a pronounced cooling in consumer spending, the main driver of growth. Intensifying macroeconomic imbalances represent the main risk to economic stability. FocusEconomics panelists expect growth of 4.4% for 2018, down 0.2 percentage points from last month, and 3.6% in 2019.

A preliminary estimate put growth in the first quarter at 3.5% year-on-year, in line with the fourth quarter last year as weaker consumption dynamics were offset by a stronger outturn in the external sector. Ahead of the comprehensive release, a mixed bag of indicators suggests household spending likely flagged in the quarter; while unemployment has been ticking down, gains in both retail sales and consumer confidence have been easing up in recent months. Fixed capital outlays, on the other hand, showed resilience as business sentiment rode a near-decade high in the quarter. Meanwhile, demand from the EU sustained manufacturing activity and drove export growth, a trend likely to have persisted into the second quarter. In late May, the ECB dashed hopes of Bulgaria’s quick adoption of the euro when it reported “serious concerns” over the country joining the ERM-II, to which Bulgarian officials had intended to apply by the end of June.

A tight labor market and public-sector wage hikes will fuel household spending this year, although inflation is expected to eat into gains somewhat. Investment should benefit from an improving business climate and low interest rates, while sound fiscal policy is expected to attract stronger FDI inflows. EU-funded outlays will continue lending support over the medium term, while upbeat European demand should underpin exports. FocusEconomics Consensus Forecast panelists expect the economy to grow 3.6% in 2018, down 0.1 percentage points from last month’s forecast, and 3.4% in 2019

CROATIA | Economy starts the year on solid footing

Recently released GDP data showed that the economy started the year on a strong note, growing 2.5% year-on-year in Q1 on the back of buoyant domestic demand, and picking up pace from the 2.2% annual expansion logged in Q4. Faster consumer spending growth—buttressed by a tight labor market and rising wages—and solid gains in fixed investment more than offset a weak external sector, which was dragged down by a marked contraction in goods exports. Moreover, upbeat activity seems to have continued at the start of Q2: the unemployment rate dipped to an all-time low in April, which, alongside improving consumer confidence, bodes well for private consumption going forward. On 25 May, a debt settlement plan for Agrokor was announced, whereby a new creditor-owned, Dutch-based company will take over the troubled firm. Creditors will vote on the proposed deal by 10 July; two thirds of them need to vote in favor for the deal to become valid.

The economy is expected to maintain a robust pace of growth this year on the heels of solid consumer spending as households continue to benefit from wage improvements and increased employment in a low inflation and interest rate environment. Furthermore, public investment is seen increasing as a result of higher absorption of EU funds. The possibility, albeit small, of Agrokor’s disorderly restructuring continues to pose a key downside risk to the outlook. FocusEconomics panelists project GDP growth of 2.7% in 2018, unchanged from last month’s forecast, and 2.7% again in 2019.

INFLATION | Inflation accelerates in April

In April, regional inflation rose from 6.5% in March to 6.9%, largely due to stronger price pressures in Turkey on solid domestic demand and a weaker currency. Romania also saw higher inflation, likely linked to the government’s expansionary fiscal policy. In contrast, inflation eased in Bulgaria and Serbia.

In response to the rapid depreciation of the lira, in late May the Central Bank of the Republic of Turkey (CBRT) hiked its late liquidity window rate from 13.50% to 16.50%. Shortly afterwards, the Bank announced a simplification of its monetary framework; from 1 June, the one-week repo rate is the main policy rate, initially set at 16.50%. After Turkish inflation rose further in May, all eyes are now on the 7 June meeting to see whether the CBRT tightens its stance in response. Serbia’s Central Bank stayed put in mid-May, following substantial easing in recent months in a bid to support inflation.

Inflation in the SEE region is expected to come in at 6.7% this year, a significant upward revision from last month’s 6.4%, mainly on higher expected inflation in Turkey and Romania. In contrast, forecasts for Bosnia, Kosovo, Macedonia and Serbia were cut this month. In 2019, regional inflation is expected to moderate to 5.8%.

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